Defining real estate markets is a bit of a fuzzy game. In many cases, they are defined as primary, secondary, and tertiary with regards to volume of sales, population, and transaction volume amount.
In general terms, Primary markets have over 5 million people, secondary markets have 2 – 5 million people, and a tertiary market has under 2 million. A given location might change category based upon other factors. For example, Detroit, which has over 5 million people, is considered a secondary market because of declining investment activity. A place like Austin, TX which has a population of under 2 million, is in the midst of a boom and could be considered a secondary market due to activity.
While commercial real estate is largely concentrated in large buildings in primary markets (from the standpoint of investment sales and press coverage), those buildings represent a small proportion of the overall stock of commercial buildings. The commercial space most of us encounter – supermarkets, small offices, warehouses, and other commercial space that is important to local communities (under 17,000 sq feet) – represent approximately 80% of all commercial space.
According to a recent Commercial Real Estate Outlook report by the National Association of Realtors, large commercial real estate markets are facing a decline in sales volume, whereas small commercial real estate markets are bullish: 2016 Q1’s 8.5 increase in sales volume was followed by Q2 rising by 8.4 on a yearly basis.
This growth is fueled in part due to upward pressure on prices, stemming from a shortage of available inventory. If you are interested in making an investment in SCRE markets and properties, this might be the right time.
In the case of many larger buildings (which you might invest in as a part of an REIT or Real Estate Investment Trust), it is likely that an existing arrangement will have been made with a property management company and a sub-set of contractors (building engineers and maintenance etc).
But, if you’re on your own and getting into commercial investing, you may have to find a property management company yourself. If this is the case, it’s important to know how a property management company could (or should) approach the management of your investment before you start shopping around.
There are potentially three types of property management scenarios you’ll be looking at: office, industrial, and retail. Of the three, Office and Retail can become very complicated.
You’ll be considering many different tenants and leases, and you must understand the potential multiple streams of income that will be coming in from your asset as a result of these contractual arrangements.
You and your property management company will seek to maintain and control a number of factors including: leases, tenants, vacancies, property maintenance activity, critical dates in leases, reporting requirements (from your PM to you), compliance and risk factors, and income and expenditure sheets.
In the case of leases, you have different types: Gross leases, Triple net leases, or hybrids of the two.
As defined by investopedia.com, “a gross lease is a type of commercial lease where the landlord pays for the building’s property taxes, insurance and maintenance. A gross lease can be modified to meet the needs of a particular building’s tenants. For example, a gross lease may require the tenant to pay the utility bills.”
Investopedia defines a triple net lease as “a lease agreement that designates the lessee, which is the tenant, as being solely responsible for all the costs relating to the asset being leased, in addition to the rent fee applied under the lease. The structure of this type of lease requires the lessee to pay the net amount for three types of costs, including net real estate taxes on the leased asset, net building insurance and net common area maintenance. This type of lease can also be referred to as a net-net-net (NNN) lease.”
There are also lease arrangements which combine elements of both gross and triple net leases. These can be negotiated between landlord and tenant.
When it comes to tenants, the lease (and the terms and conditions thereof) and tenant requirements (eg the option to expand into new space or contract as needed) will have to be negotiated. You’ll want to find right cluster of tenants – anchors (larger businesses) and specialty tenants (merchandisers or small restaurants, for example) to ensure that your property maintains its value and cash flow.
You’ll want to closely monitor vacancy, and ensure a low vacancy factor for your property. Market factors will come into play, and you’ll want plans in place to help resolve vacant space and find new tenants. Vacancy can also give you time to renovate or refurbish your property, so it can also be beneficial – if anticipated.
Strategic lease renewals will also be useful. If you’ve locked a tenant in for a 5 year lease, don’t wait until that lease is nearly expired to re-negotiate – step in a year or two early and extend to ensure your cash flow.
Last of all, property maintenance will be an important factor in your commercial real estate investment. Each fiscal year, you’ll establish budgets to track the expenditure side of cash flow, itemize your capital expenditures, prepare for planned and unplanned maintenance costs, and allocate reserves on an annual basis. This amount will vary depending on the age, quality and amount of deferred maintenance of the property
As you can see, there are a lot of considerations that come into play after you’ve decided to make your initial investment in a new property. Make sure you’ve done your research and find the right property management specialist – your investment has a much better chance of flourishing with the right team in place.
Be able to ask questions as you interview a potential project management co, such as: “What is your policy and rate for establishing strategic lease renewals?” Or “What, if anything, do you do to market vacant space or planned vacant space?” This will give you a better idea of the nature of your potential management firm, and how they approach property management.